FBIAS™ for the week ending 5/30/2014

In the “decades” timeframe, we have been in a Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E, or “CAPE”) peaked at about 44. The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge. See graph below for the 100-year view of this repeating process.

If history is a guide, we may not yet be done with this Secular Bear Market. The Shiller P/E is at 25.9, up a little from the prior week’s 25.6 and approximately at the level reached at the pre-crash high in October, 2007. Even though P/E’s are substantially lower than their crazy peak in 2000, they are nonetheless at the high end of the normal historical range and leave little if any room for expansion. This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that. (note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see robertshiller.com for details).

In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see graph below).

This further means that above-average returns will be much more likely to come from the active management of portfolios than from passive buy-and-hold. Although a mania could come along and cause P/E’s to shoot upward from current levels (such as happened in the late 1920’s and the late 1990’s), in the absence of such a mania, buy-and-hold investors will likely have a long wait until the arrival of returns typical of a Secular Bull Market.

In the big picture:

The “big picture” is the months-to-years timeframe – the timeframe in which Cyclical Bulls and Bears operate. The US Bull-Bear Indicator (see graph below) is at 65.7, up from the prior week’s 63.6, and still solidly in cyclical Bull territory. The current Cyclical Bull has taken the US and some of Europe to new all-time highs, but many of the world’s major indices have yet to top 2007’s levels. The most widely followed international indexes, the Morgan Stanley EAFE Developed International index and the Morgan Stanley Emerging Markets Index, are both still below their 2007 peaks.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) remains in positive status, ending the week at 29, up two from the prior week’s 27. Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of April for the prospects for the second quarter of 2014.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2 above), the Secular Bear still may still be in force as the long-term valuation of the market is simply too high to sustain a new rip-roaring Secular Bull. In the Cyclical (months to years) timeframe (Fig. 3 above), all major equity markets are in Cyclical Bull territory. The Bond market returned to Cyclical Bull territory as of February 28th. In the Intermediate (weeks to months) timeframe (Fig. 4 above), US equity markets remain in positive status. The quarter-by-quarter indicator gave a positive signal for the 2nd quarter: both US and International equities were in uptrends at the start of Q2, which signals a higher likelihood of an up quarter than a down quarter.

In the markets:

LargeCap Tech has snapped back from the recent technology pullback and set a 14-year high during the week. The LargeCap Tech index, the Nasdaq 100, lead all US indices for the week and for the month of May, and finished May up +4.0% for the year to date. The Nasdaq 100 gained +1.6% for the week, and +4.3% for the month of May. The next best US index was the S&P 500, gaining +1.2% for the week and +2.1% for the month of May. It, too, is up +4% for the year to date. The Russell 2000 SmallCap Index is now the only US index in negative territory for the year to date, at -2.5%. Developed International gained +1.0% for the week, and gained +1.6% for the month of May. The Emerging Markets index lost ground last week at -1.4%, affected by Brazil’s -2.8% setback. Canada’s TSX lost -0.7% for the week, and finished May essentially flat for the month but remains well ahead of the US year to date at +8.6%.

The biggest economic news in the US during the week was the release of the revised first-quarter GDP – which was far softer than expected at -1.0% after the initial release showed a gain of +0.1%. It will be very difficult for the economy to now meet the consensus expectations for a 3%-4% GDP gain for the entire year. April durable goods was disappointing at +0.8%, which on the surface was a good number, but it turns out it was basically all defense-related, including a single large nuclear submarine order. Taking out defense, orders were actually down -0.8%. But the Chicago Purchasing Managers Index (“PMI”) for May was a very strong 65.5, much better than expected, and the S&P/Case-Shiller home price data for March was likewise solid, with prices in the 20-city survey group up +12.4% over March 2013.

GDP was likewise topic number one in Canada for the week. GDP grew at a +1.2% annualized pace in January through March, according to Statistics Canada – a substantial slowdown from the Q4 +2.7% pace. Economists surveyed by Bloomberg had predicted growth would slow, but to a higher +1.8 percent pace. The slump was broadly based and included contractions in investment spending by businesses and housing construction. Home building recorded its biggest quarterly decline since the 2008 recession, falling an annualized -6.3%. So did final domestic demand, a measure that excludes the trade sector, which fell by an annualized -0.3%. Positive contributions by industry segment came from oil and gas, with construction and services-related businesses such as wholesalers and retailers among the biggest drags.

A comment two weeks ago about the frequency of SmallCap pullbacks of 10% or more, and whether the divergence between SmallCap and LargeCap performance portends anything, drew a number of comments and questions. The most-asked question was “What is the frequency of LargeCap pullbacks of similar magnitude compared to those SmallCap pullbacks?” Here is a graphic which answers that question nicely – showing that during Cyclical Bull Markets there are many more SmallCap pullbacks of double-digit magnitude than LargeCap, and again showing that SmallCap pullbacks are not necessarily predictive of…anything. (the Russell 1000 is a LargeCap index, similar to the S&P 500)

Source: 361capital.com

The Eurozone awaits the European Central Bank (“ECB”) meeting this week, where it is expected that Mario Draghi will announce steps to combat looming deflation in many of the European Union countries. Germany’s unemployment rate ticked up for the first time in 6 months. France announced it had overestimated tax receipts for the year, with actual tax receipts coming in at barely more than 50% of the projected amount – despite France having raised income tax, VAT and corporate tax rates all since Francoise Hollande came to power. Skeptics insist that France’s government was lying all along about probable tax receipts in order to avoid ECB-mandated budget cuts.

The “chickens are coming home to roost” regarding the business costs of the NSA spying programs that have been revealed to include the insertion of spy chips and software into the regular products of the likes of IBM, Cisco Systems and others (without necessarily any cooperation from the manufacturers themselves). The Chinese government is now strongly urging Chinese domestic banks to remove high-end servers made by IBM and replace them with domestic brands, with the People’s Bank of China and the Ministry of Finance saying the reliance on IBM specifically and US companies in general compromises the country’s financial security. The Financial Times also reported that Chinese state-owned companies have been ordered to cut ties with U.S. consulting firms.

The ranking relationship (shown in Fig. 5) between the defensive SHUT sectors (“S”=Staples [a.k.a. consumer non-cyclical], “H”=Healthcare, “U”=Utilities and “T”=Telecom) and the offensive DIME sectors (“D”=Discretionary [a.k.a. Consumer Cyclical], “I”=Industrial, “M”=Materials, “E”=Energy), is one way to gauge institutional investor sentiment in the market.

The average ranking of Defensive SHUT sectors fell to 11.0 from the prior week’s 10.3, while the average ranking of Offensive DIME sectors was unchanged at 12.3. The Defensive SHUT retained a slight lead over the Offensive DIME sectors.

Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.

Summary:

The US led the recovery from 2011’s travails, and continues to be among the strongest of global markets. However, the over-arching Secular Bear Market may remain in place even as new highs are reached in the US.

Because we may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence. Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.

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